Grillo's Corner: The Great Central Bank Roller Coaster

By
Paul Grillo

April 27, 2012

Deleveraging: The defining trend of recent years

As I have maintained over the past three years, the one condition that continues to define the current environment is debt deleveraging. Most strategists and economists have never confronted an environment like this, so they continue to project more-normal levels of recovery that one would expect from most post–World War II recessions. However, the voluntary, and involuntary, deleveraging actions have forced a much longer recovery period from the global financial crisis.

Rapid growth in debt*

Deleveraging

Sideways

Japan

South Korea

Germany

Spain

United States

Canada

France

Australia

United Kingdom

Italy

*Defined as an increase of 25 percentage points or higher.

Since the peak of the financial crisis, only three major economies in the developed world have had success in reducing their levels of sovereign debt.

Data: McKinsey & Company, obtained in April 2012.

According to the consultants at McKinsey & Company, from the point at which the global financial crisis was at its maximum intensity, only three major developed countries have made some progress in deleveraging: South Korea, the United States, and Australia. Other countries have mostly gone sideways. However, three significant economies — Japan, Spain, and France — have increased their levels of debt. Many countries originally expanded their government debt (fiscal stimulus and/or automatic stabilizers) to help their societies through the challenging economic times of recent years. Other areas of debt have declined (finance company and consumer debt) due to mostly involuntary measures (such as default). Much more deleveraging has to happen, in my opinion, because assets that had been financed with significant debt can no longer support the burden of interest and full maturity payments. This is economically painful as credit tightens in the downturn, and wealth takes a hit as savings pools take fractional payments on their bond investments.

Additional liquidity: The global central banks’ answer to the crisis

This brings us to the central bank responses. The current Federal Reserve chairman, Ben Bernanke, did intensive work/study on the Great Depression era in his academic life. Reportedly, one of his most important conclusions about that period was that insufficient liquidity, by the Federal Reserve, caused the U.S. economy to recollapse in 1937, and postponed the recovery. Mr. Bernanke does not want to repeat that policy error.

My astute Australian colleague Brett Lewthwaite notes that, in recent years when deflationary winds have started to blow in the U.S. economy, Chairman Bernanke has started the printing presses, hitting the economy with liquidity via quantitative easing (or QE). The graphs below highlight this phenomenon: Since mid-2008, the Fed has introduced some form of QE after each time break-even rates on 10-year Treasury inflation-protected securities (TIPS) — an indicator that shows expectations of inflation in an economy — have dipped below 2%.

Starting in mid-2008, the Fed’s balance sheet has expanded exponentially, as it has introduced new forms of liquidity each time the U.S. economy has faced deflationary pressures.

Data: Federal Reserve, obtained in April 2012.

Data: Federal Reserve, obtained in April 2012.

The Federal Reserve is not alone in supplying ample liquidity. Four other central banks are currently involved in liquidity actions. The Bank of Japan has maneuvered to limit further appreciation of its currency by printing additional yen to sell into the markets. The Bank of England is engaged in asset purchases to infuse banks with more liquidity. The Swiss National Bank is printing francs to sell against other currencies, especially the euro. And finally, the European Central Bank (ECB) is buying distressed European government bonds, but also engaging in a massive financing scheme to solve liquidity and funding problems in European banks.

Once climbing steadily, the slope of the ECB’s balance sheet grew steeper in 2011, as the ECB aimed to solve liquidity and funding problems in European banks.

Data: Bloomberg, obtained in April 2012.

The downsides of liquidity

The asset purchase activity takes investment supply out of the private markets, often times pushing investors into alternative investments. In this way, commodity and equity markets have benefited in recent years when money is moved into those markets. Bond sectors like high yield and bank loans also have benefited from this activity. When the liquidity effect wears off, however, markets typically reverse and head lower, leaving many market participants with the feeling that they are on a roller coaster.

The issue with these liquidity programs, in my opinion, is that they have the potential to create more inflation than intended (the commodity surge that took place during QE2, for example). Moreover, they tend to divorce risk markets from fundamentals. It has been stated that the current environment of significant global central bank intervention creates an effect of “all corporations having the same CEO” (Ben Bernanke, in this case). Company management decisions matter much less than billions of dollars of potential liquidity.

Additionally, the moral hazard risk has grown, in my view, as the liquidity programs have continued. A major fault of the Alan Greenspan–era Fed, in my opinion, was the creation of what many called the “Greenspan put.” If the markets got into trouble, Mr. Greenspan would typically be there to provide ample liquidity in an attempt to save the day. That led to a major mispricing of risk assets going into 2007 and 2008, and finally, in my opinion, led to the global financial crisis.

What calamity could this current intervention lead to? Societies, which would suffer under a Depression-era-type deleveraging, are patiently waiting through these liquidity exercises because they deliver immediate relief, if only temporarily. We do not know the longer-term effects of these actions, but I am fearful.

Our approach during the roller coaster

Given this new investment landscape, it is often hard to make portfolio decisions as asset prices move sharply back and forth. Compounding this difficulty is a never-ending cadre of “specialists” who provide fundamental reasons for what are, in effect, liquidity-driven moves. What is an investor to do?

We believe investors are best served by sticking to established themes that conform to today’s macroeconomic and investment environment. Within the U.S., these themes include: (1) an improved banking sector (after significant deleveraging and recapitalization), (2) a corporate sector that has (generally successfully) taken steps to address a challenging economic landscape, and (3) U.S. growth that will remain challenged as the country deals with its bloated public-sector debt and promises to retirees (future liabilities).

Moreover, European growth is at significant risk as Europe tackles the dual task of bank and public-sector debt deleveraging. Finally, global growth potential has fallen as China copes with imbalances in the private sector (a superheated real estate sector, and comparatively low domestic demand when compared to internal levels of investment). With this in mind, emerging countries face growth headwinds but, in my opinion, have the fiscal, monetary, and currency reserve “ammunition” to deal with these economic fires.

Across the funds we manage, we have maintained overweights to the corporate sector, but we remain mindful of our European exposures. We have investments in what we consider to be high-quality sovereign investments and emerging market debt (sovereign and corporate exposure). Within our multisector portfolios, we are currently maintaining tail-risk hedges in case various policy measures prove inadequate. Interest rate sensitivity has not been dampened at this stage because, in our opinion, interest rates should stay far lower than the mainstream media and popular strategist-types project.

Good luck to us all.

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Paul Grillo biography

Paul Grillo, CFA

Paul Grillo is a member of the firm’s taxable fixed income portfolio management team with primary responsibility for portfolio construction and strategic asset allocation. He is also a member of the firm’s asset allocation committee, which is responsible for building and managing multi-asset class portfolios. He joined Delaware Investments in 1992 as a mortgage-backed and asset-backed securities analyst, assuming portfolio management responsibilities in the mid-1990s. Grillo serves as lead portfolio manager for the firm’s Diversified Income products and has been influential in the growth and distribution of the firm’s multisector strategies. Prior to joining Delaware Investments, Grillo was a mortgage strategist and trader at Dreyfus Corporation. He also worked as a mortgage strategist and portfolio manager at Chemical Investment Group and as a financial analyst at Chemical Bank. Grillo holds a bachelor’s degree in business management from North Carolina State University and an MBA with a concentration in finance from Pace University.

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